9 and 10 please

Aspeon Sparkling Water, Inc., botlles pure Rocky Mountain spring water and sells it through independent distributors located throughout the continental United States. The company owns and operates regional warehouses in St. Louis. Buffalo, Jacksonville, and Los Angeles. Basically, Aspeon sells its water to wholesale distributors who have exclusive rights to a given territory. Then, the distributors sell it to supermarkets within their region. Additionally. Aspeon is responsible for marketing the product nationally. The company was founded in 1981 by Beth Poe, then a recent graduate of the University of Michigan. Beth grew up in Aspen, Colorado. She knew that consumers were becoming more health conscious, and she recognized a demand for clean, fresh-tasting water. After returning to Colorado upon graduation and convincing her wealthy parents to become silent partners, she obtained the necessary equity capital to build a plant. Aspeon grew rapidly from its initial customer base in Colorado. and by 1988 Aspeon water was on virtually every supermarket shelf in America. Beth was a dedicated believer in the virtues of equity financing. Although the company had used debt financing in the early years to finance the regional warehouses, Beth always used Aspeon's cash flows to retire the debt as soon as possible. Beth believes that the market for her company's product has finally matured. First, numerous bottled-water companies, such as Zephyrhills and Evian, have appeared on the scene. Second, it is extremely difficult to differentiate Aspeon from other brands of water. Third, the product is currently sold throughout the country, and there are no additional markets to enter. Thus, Beth expects Aspeon's 1993 earnings before interest and taxes (EBIT) of $32 million to remain relatively constant into the foreseeable future. Aspeon has 10 million shares of common stock outstanding, which is traded in the over-thecounter market. The current stock price is $12.00, so the total value of Aspeon's equity is $120 million. The book value of the firm's stock is also $120 million, so the stock now sells at its book value. Beth owns 20 percent of the outstanding shares, and others in the management group own an additional 10 percent. The company's financial manager, Emily Martin, has been preaching for years that Aspeon should use debt in its capital structure. "After all," says Emily, "everybody else is using at least some debt, and many firms use a great deal of debt financing. I don't want to put the firm into the junk bond category - that market has been hammered over the past few years-but I do think that the judicious use of debt can benefit everyone. Also, by being unleveraged, we are just inviting some raider to line up a lot of debt financing and then make a run at our company." Beth's reaction to Emily's prodding was cautious. However, since one of Beth's friends just lost his unleveraged company to a raider, she was willing to give Emily a chance to prove her point. Emily had worked with Beth for the past six years, and the knew that the only way she could convince Beth that the firm sheuld use debt tinanciag would be to conduct a comptehensive quan. titative analynis. To begin. Emily larranged for a joint meetine with her forruer finance prolessor. and an investment banker who specializes in corparate financing fo: consumer products compa: mies. After several hours, the trio agreed on these extimates for the relationships between the ammant of debt financing and Aspeon's clpital costs: If Aspeon recapitalizes, the borrowed funds would be used to repurchise the firm"s stock in the over-the-counter market. The firm's federal-plus-state tax bracket is 40 percent. The effective personal tax rate on income from stock is 25 percent and on income from debt is 30 percent. With these data in hand, Emily mest now complete an analysis designed to convince Reth to use some debt financing. Assume that Emily has passed the assignment on to you, her assistant, for: answers. She suggests that the presentation to Beth begin by diseussing various types of risk, how risk is measured, how risk affects capital structure decisions, and how the analysis would change if Aspeon's business risk were significantly higher or lower than originally estimated. As a starting point to finding the optimal capital structure, Emily suggests calculating Aspeon's stock price, number of shares remaining after recapitalization, EPS, and WACC at cach debt level. Beth previously indicated that she did not completely understand the relationships between the amount of debt, EPS, stock price, and WACC. Beth discussed the firm's situation with various friends of hers who are financial analysts. Each has given Beth advice on what factors to consider in the analysis. Beth highly regards her friends" expertise and forwards their comments to Emily to consider in the analysis. For example, Henry. Rathbone, a financial analyst in the botted-water industry, believes that although ASpeon's EBIT is expected to be $32 million, there is a great deal of uncertainty in the estimate. He formalated the following probability distribution: Henry suggests conducting an ROE and TIE analysis at each EBIT level under two capitalization alternatives: all equity capital structure with $120 million of stock, or $60 million of 13 percent debt plus $60 million of equity. Jenny Lippincott, another of Beth's friends who is aware of her aversion to debt financing. informs her that the new debt could be added in phases instend of all at once. Thus, assuming that. Aspeon recapitalized with $25 million of debt (hence S=$107,272.727,D=$25,000,000,V= $132,272,727,P=$13.23, and n=8,109,966 ), Jenny proposes two future altematives: Aspeon could increase its debt to $50 million by issuing $50 million of new debt and using half to refund the existing issue and half ro repurchase stock, or it could issue $25 mithion of ncw debt without refunding the first issue. Eimily would like each proposal evaluated to ascettain its impact on stock price. Beth also sought advice concerming Aspeon's capital structure from Jean Claude Van Lamb, her college finance professor. Professor Van 1.nmb scolded Beth for not remembering two capiti structure theories taught in class: the Modigliani-Miller with corporate taxes and the Miller model. For simplicity's sake, he suggested using $120 million as the value of the unlevered firm in both models when calculating Aspeon's value. Beth wants both models used to determine Aspeon's value at $75 million of debs. She is also unsure why the three models (MM. Milier, and the EBrr/capital cost model), all of which are designed to calculate value, yield different results. Beth is often skeptical of financial tbeorics. Therefore. Bmily recommends addrensing the weaknesses of the analysis as well as other approaches that coutd be used to determine an appropriate target capital structure for Aspeon. Emily has a strong finance background, and Beth is an excellent businesswoman with good instinets. Be sure to be prepared for follow-up questions. 3. Since Aspeon is not expected to grow. Emily believes that the following equations can be used in the valuation analysis: (1) S=[EBITkd(D)](1T)/ki (2) V=S+D (3) P=(VD0)0 (4) n1=n0D/P (5) VL=VU+TD (Modigliani-Miller) (6) VL=VU+[1(1Tc)(1Ts)/(1Td)]D (Miller) Here. S=marketvalueofequityD=valueofdebt EBIT = earnings before interest and taxes kdDD0TTc=costofdebt=market(andbook)valueofnewdebt=marketvalueofolddebt=taxrate=corporatetaxrate Ts = tax rate on income from stock Td=tax rate on income from debt ks=cost of equity V= total market value P= stock price after recapitalization n0= number of shares before recapitalization n1= number of shares after recapitalization a. Explain the logic of Equation (1) for a zero-growth firm. b. Describe briefly, without using numbers, the sequence of events that would occur if Aspeon decided to recapitalize. 8. Now consider two capital struciure theories: Modigliani-Miller with corporate taxes (MM63) and the Miller model. a. What would Aspeon's value at $75.0 million of debt be, according to the MM63 model? b. What would the firm's value be, according to the Miller model? (Assume that the personal tax rate on income from stock [Ts] is 25 percent, and the personal tax rate on income from debt [Td] is 30 percent. Also, use $120 million as the value of the unlevered firm [VU] in both the MM63 and Miller models, even though it should be less in the Miller model.) c. Why do the values differ when calculated by the equations in Question 3, the MM63 model, and the Miller model? (Hint: Consider the assumptions that underlie each model.) 9. How do control issues affect the capital structure decision? 10. Consider the usefulness of this analysis for most firms. a. What are the major weaknesses of the type of analysis called for in the case? b. What other approaches could managers use to help determine an appropriate target capital structure? c. Is the target capital structure best thought of as a point estimate or as a range? d. What other factors should managers consider when setting their firms' target capital structures